Outlook on fixed interest markets in 2023 and beyond

Aaditya Thakur, Senior Vice President and Portfolio Manager at PIMCO

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In this episode, Aaditya Thakur, Senior Vice President and Portfolio Manager at PIMCO, joins us to unpack the reasons why 2022 was such a challenging year for fixed interests and how this impacts 2023 and beyond. He explores inflation, recession risks, the implications of China reopening, as well as the positive developments in the market and what this means for fixed interests and investors constructing their portfolios.

 

Transcript

Paul O’Connor:

My name's Paul O'Connor and I'm the Netwealth's head of strategy and development for investment options.

Today, Aaditya Thakur, from PIMCO, joins us to discuss his outlook for bond markets and the global economy in 2023.

Mr. Thakur is a senior vice president and portfolio manager in the Sydney office, focusing on the Australian dollar and global portfolios. Prior to joining PIMCO in 2013, Aaditya was with AMP Capital Investors as a portfolio manager within the fixed income macro markets team.

He has 17 years of experience and holds a master's degree in commerce, in finance, from the University of New South Wales and an undergraduate degree from the University of Wollongong. Aaditya here is also a CFA charter holder.

So good morning and welcome to the Netwealth Portfolio Construction Podcast Series.

Aaditya Thakur:

Good morning, thanks for having me on.

Paul O’Connor:

Pacific Investment Management Company or PIMCO, is primarily a fixed income manager, but also offers capabilities in commodities, alternatives and even equities, although to a much lesser degree. PIMCO have offices in North America, Europe, Asia, and Australia, and is owned by Allianz Global Investors, a subsidiary of the Munich based Allianz group. As of 30th of June, 2022, PIMCO managed us $1.8 trillion in assets under management and employee over 300 portfolio managers globally. So we'd certainly consider them a very well resourced company. There are 10 PIMCO managed funds available on the Netwealth Super and IDPS investment menus, including two Australian fixed interest strategies, seven international fixed interest strategies and one alternative strategy. In 2022, the major themes impacting on the market were inflation, heightened geopolitical risk and China's lockdowns to attempt to prevent the spread of COVID. The rise of inflation certainly caught many market participants off guard, and I guess was effectively driven by a combination of supply chain shortages due to COVID, commodity price rises, namely in energy, post the Russian invasion of Ukraine, and the end of extraordinary monetary policy by many of the developed world central banks.

The Russian invasion of Ukraine was a catalyst that drove significant price increases across both hard and soft commodities, with energy costs rising the greatest, based on Russia's role as a primary supplier of energy to Europe and the Middle East. This coupled with an increasing drive by economies to transition to clean energy has certainly resulted in driving the surge in energy prices. And finally, I guess China's continued lockdowns in response to COVID, material impacted on their economic output, resulting in GDP growth of around 3% in 2022, which I guess is a market slowdown, considering China's annual GDP growth has averaged in excess of 6% per annum over the last decade. The above risk factors resulted in global equities generating negative returns in 2022, falling property valuations across most developed markets, and losses in bond funds as long-term yields rose. 2022 can be considered a remarkable year in many ways, and particularly the negative return in bond markets, they have not produced such disappointing returns since 1994.

On a positive note, the normalisation of cash rates is a positive for investors, but real returns still remain negative and the yield curve flat. So I'll be interested to discuss these challenges with Aaditya today. So maybe to start with Aaditya, can you provide the listeners with a few comments on your journey to being a fixed interest portfolio manager with PIMCO in the Sydney office?

Aaditya Thakur:

Sure. Yeah, as you mentioned, I first started in fixed income quite a while ago, about 17 years ago at AMP Capital, within the fixed income team. I had a kind of a variety of roles there, predominantly in the macro markets teams, looking at kind of global macroeconomics interest rates strategy, but I also did a lot of trading for our credit team in the investment grade credit space. And then following that, I joined PIMCO just nearly 10 years ago now, and I've been in a fairly similar role. We've got a smaller team here that obviously plugged into our global portfolio management team and we've got what we describe as more of a generalist role here, we cover across our risk factors, which include interest rate strategy, credit and foreign exchange. So it's been about 17 years in the market.

Paul O’Connor:

And were you always attracted to bonds or capital markets, global macro themes or how did you end up working in, I guess, bonds?

Aaditya Thakur:

Yeah, it was one of those things, I didn't specifically plan it, but during the time I was doing my master's in finance, I really just gravitated towards the subjects which were more to do with interest rates, macroeconomics and ultimately fixed income. And the opportunity just arose when I was working at AMP, to get a kind of junior position within the fixed income team. And I guess the rest is history.

Paul O’Connor:

Rest is history as they say. Well, moving on to the questions for today's podcast, central banks are hopefully nearing the end of their hiking cycle after an extraordinary 2022, which saw central banks normalising monetary policy in an attempt to combat a rapid rise in inflation. What do you think this means for the fixed interest asset class in 2023?

Aaditya Thakur:

Yeah, I think there's going to be two kind of shifts this year relative to last year. From a macroeconomic perspective, clearly last year was all about inflation and the big surprise is that we got to inflation from three primary shocks. So firstly, the supply side shocks from COVID. Secondly, fiscal stimulus shocks, particularly out of the US. And then thirdly, as you talked about previously, the shock to energy and commodity markets resulting from the Russian invasion of Ukraine. I think this year the shift will become more balanced between inflation and growth, particularly as growth concerns start to pick up. As we see the impact of last year's tightening in global monetary policy start to really hit global economies and economic data, the focus for markets and investors will shift towards growth concerns and I think recession risks will once again start to rise. And so that's typically a period where defensive asset classes will start to outperform and there'll be a rush towards liquidity.

Illiquidity risk will start to go up and investors should really start to think about increasing the liquidity in their portfolios now. So I think that shift from primarily concerned about inflation to being more balanced around growth and inflation, I think that will be a primary driver that will support fixed income markets this year. And secondly, I think last year there was so much uncertainty, central banks were caught off guard by the elevated levels of inflation and the spike in inflation, they were a little bit behind the curve and had to start raising rates very rapidly at a pace of tightening that we hadn't seen in a generation. And now we're kind of starting to approach the end point of that hiking cycle.

So just naturally, volatility and uncertainty starts to come down. And when we kind of think about that in terms of markets, uncertainty is expressed in terms of volatility and if volatility starts to come down and at the same time, return prospects have gone up because yields have risen very sharply and carry for portfolios is much higher. So your expected return, which is your yield per unit of risk, which is your volatility measure, that ratio is also starting to improve. So that is also another reason or another tailwind that will start to support the asset class after quite a horrible 2022. So I think they're the two things that we're kind of focused on for this coming year.

Paul O’Connor:

So we've seen softer inflation data in the US in recent months, whereas inflation in Australia still remains at multi-decade highs. And I guess there's also that transmission lag between when interest rates rise and how long it takes to actually impact on the economy. So what are your expectations for inflation for the course of 2023 and what implications does this have for the trajectory of interest rates?

Aaditya Thakur:

Yeah, I think in Australia, clearly the inflation pulse lagged other countries by one or two quarters, so it wasn't that much of a surprise to see inflation continue to rise. In Q4 last year, headline inflation hit 7.8%, which was around the RBAs forecast for the year-end. An underlying inflation, which is their kind of preferred measure, that was the component that really surprised to the upside, and was about half a percentage point higher than RBAs expectations. But we still think that Q4 marks the peak in inflation in Australia as well. We think that inflation will start to moderate now quite sharply. The RBA kind of expects inflation to ease back to around 4.75% by the end of 2023 and then get back to around 3% by the end of 2024. We think the descent will be a little bit faster in 2023. So we're kind of expecting inflation to fall closer to kind of 4%, which is a touch lower than consensus and obviously a fair bit lower than the RBA, but then also kind of near 3% by the end of 2024. So we just think that descent will be a little bit faster.

Why do we think that? We think that the aggressive increase in mortgage rates, and you kind of alluded to the fact that there is a bit of a lag in monetary policy affecting the broader economy, we think that that will really start to bite our economy around Q2 onwards and particularly the second half of this year. And that will really start to constrain household consumption. We also think that goods disinflation, which is quite apparent in other countries, we've yet to see that in Australia. Goods inflation was still rising in Q4. So we think that that will start to come off and help inflation ease. And with China reopening, that should really just improve those prospects as supply chain issues start to be resolved a bit quicker.

So as a result, we think that should inflation come off a bit more than what the RBA expects and more in line with our expectations and our forecasts, we think that that will allow the RBA to pause their hiking cycle. We kind of expect the cash rate to end up somewhere between three and a half to 4%, so a little bit below what the market is now starting to price. And we think that once the RBAs on pause, that should start to support bond markets, domestic bond markets as well.

Paul O’Connor:

Yeah, I think I saw a figure the other day that for example, fixed term mortgages that were fixed in maybe 2019, 2020 that are rolling off this year, will result in a circa additional $5 billion in payments when they move to floating rate mortgages. And it's, I guess, examples like that that will have an impact on calling the economy naturally there. But it's such an inexact science at the end of the day, what the RBA are trying to achieve. So I do have some sympathy for the RBA and the work that they are tasked with at present there. It's a fine line central banks are trying to tiptoe, in terms of slowing their economies just enough to cool inflation, but obviously not destroying growth and tipping economies into a recession. So do you think there's a possibility that central banks will go too far in their battle against inflation, and how can investors protect their portfolios in this type of scenario?

Aaditya Thakur:

Yeah, it's a really unenviable task for central banks at the moment. If we think about monetary policy, that works with quite long lags, so typically kind of nine to 18 months depending on the country. So really the hikes from last year, they'll only really start hitting the broader economy and the macroeconomic data showing up in the data from around Q2 onwards this year. So really central banks have to make some judgements on the underlying trends of inflation and about labour markets, but they're kind of relying on data that's a little bit lagged. So it's a difficult and unenviable task. And at the same time, central banks are also concerned that should we have a prolonged period of very high outright levels of inflation, inflation that's much higher than their target levels, then they're concerned that broader inflation expectations amongst the public will start to rise. And that's something that they really have no tolerance for whatsoever, and that's a bigger risk for them.

So the crux of the problem for them today is that the longer that we have these elevated levels of inflation, the higher the risk that broader inflation expectations start to rise, and the central bank reaction function will then become much more singularly focused on keeping those inflation expectations low. They'll be more than willing to sacrifice growth and have unemployment rise to ensure that the inflation expectations remain kind of well anchored. So should that happen, that patience for allowing those lags of monetary policy to take effect, that patience will start to diminish. And that's really how you end up with, in prior cycles, particularly inflationary kind of cycles, you end up with central banks over tightening and pushing kind of economies back into recession. That will then mean that unemployment will start to rise, there'll be greater slack in the labour market, and inflation will then start to come off a bit faster than expected. So that certainly remains a big risk, certainly for this cycle.

Paul O’Connor:

And I guess to your point, if it becomes embedded in the psyche of the economy, it becomes self-fulfilling, the further fueling of inflation. So I can appreciate your comment there that the RBA will be doing everything to try and ensure that does not occur and they will even sacrifice some level of unemployment and risk that they slightly go overboard with the rise in interest rates to cool the economy there. So the impending recession of 2023 seems to be the most telegraphed recession in recent memory. What are some of the risks to this consensus not playing out and do you believe the US is currently in a technical recession?

Aaditya Thakur:

Yeah, I think when we talk about recession risks, clearly it's gotten a lot of media airtime, but we really have to think carefully about what is the market actually pricing, what degree of recession risk is the market pricing? And at the moment, given the more recent economic data, both globally and domestically, has been showing a degree of resilience and given those monetary policy lags that I spoke about previously, really mean that we won't see the full impact of higher interest rates until more than likely Q2 onwards this year. Asset classes aren't pricing in an excessive amount of recession risks. When you look across credit spreads relative to their long-term history, when you look across equities and equity risk premia and whatever measure you want to use for basic valuations like PEs, they're not by any means pricing in a particularly high risk of recession. So I think that's one thing to keep in mind because should we start to see economic data deteriorate and unemployment rates start to rise, then there's plenty of scope for the market to start pricing in much higher levels of recession risk.

Now, in the bond market, I think it's fair to say it's pricing in slightly higher levels of recession risk across various indicators. If you look at the degree of inversion in yield curves, so the downward sloping nature of yield curves, or if you look at market's expectations for some degree of rate cuts, particularly in 2024, in the US, the market's pricing in roughly 140 basis points of rate cuts through mostly 2024. Now, when you think about the end of most economic hiking cycles, once economies do tip into recession, the central bank can deliver somewhere between 250 to 350 basis points of cuts on average. So the bond market is starting to price in recession risk, but it's not anywhere near fully priced. So I think I'd just keep that in mind. But secondly, we do talk about recession being kind of consensus or well telegraphed, but that doesn't mean that it won't play out.

And in fact, if recession sentiment remains elevated, it can become self-fulfilling. If people are genuinely worried about recession, if they're genuinely worried about losing their jobs, then businesses will be reticent to expand. They'll be hesitant to invest or hire. And obviously households may start to raise their precautionary savings levels, especially if you start to think that your job may be at risk. So this is what in economics they would call the paradox of thrift. If we all start to save because we're worried about the future, then we all end up poorer. We need some cohort, we need some part of the economy to continue spending. So the recession sentiment can become self-fulfilling, it's not something that just because it's well telegraphed doesn't mean that it won't be avoided. As for the US, whether it's in technical recession, clearly the more recent economic data doesn't suggest that the economy's in recession.

If anything, it's showing a higher degree of resilience, but we are seeing more forward-looking indicators start to slow down. We're seeing the PMI data series, so a series of business surveys across manufacturing and service sectors, start to fall. And that series, when it falls below 50, it starts to ring alarm bells around future growth prospects. We're starting to see forward-looking indicators such as the ratio of new orders to inventory in a lot of those surveys, also start to fall. We're obviously seeing house price declines across most developed markets, and we're starting to see some softening in forward-looking labour market indicators as well. And in Australia domestically, we've seen a couple of weaker retail sales prints, we've seen some easing in labour market conditions, and even just some of the anecdotes from the retailers start to suggest that demand is starting to come off the boil in the new year. So we're watching those things very carefully, but we wouldn't say that the US is currently in technical recession.

Paul O’Connor:

So the last 10 years have been dominated by central bank intervention, I guess via accommodative monetary policy and extraordinary monetary policy being quantitative easing. So when central banks stop or slow their hiking cycle, there'll still be a natural, I guess, shadow tightening via quantitative tightening, where effectively, I guess, the central banks are just letting the bonds run off the balance sheet. So what are some of the ramifications of this for investors and portfolios?

Aaditya Thakur:

Yeah, that's right. We will be having, in the background, even if central banks do pause their hiking cycles, we will be having this kind of shadow tightening in the background. So in other developed markets like in the US, in Europe, in the UK, the central bank is actually selling back some of the bonds assets that they purchased during the QE period, they're actually selling them back to public markets and withdrawing liquidity from the market. In Australia, the RBA isn't actively selling back the bonds they purchased during the QE period, but they will be letting those bonds mature. But what we will be witnessing in Australia is the maturity of the term funding facility. So that was very cheap funding that the RBA provided to our banks directly. A lot of those loans will be maturing and the banks will have to replace those loans from the RBA with debt issuance in the public market. So they'll again be kind of shadow tightening in Australia without kind of QT.

So what will that mean? Well, if we think about QE, QE was aimed at increasing liquidity and lowering risk premia. It forced investors, it pushed investors out the risk spectrum, out of cash and into more risky asset classes. So QT really works in the opposite direction. It will be the withdrawal of liquidity, it'll be the increase of risk premia and in conjunction with higher cash rates, the hurdle rate or the opportunity costs for taking risk for moving out of cash and into more risky assets, that opportunity cost or that hurdle rate is becoming much higher.

So investors should really be wary of this in their overall portfolio construction, you shouldn't fight the fed or central banks on the way in, and you shouldn't fight them on the way out. The window for increasing defensiveness and increasing liquidity in portfolios is now closing, and that's really what investors should concentrate on now, I think, particularly whilst wearing this period before the worst of the economic data starts to deteriorate, that should really be the focus of investors. And I guess the good news is that those defensive asset classes like cash, like fixed income now offer really attractive yields and investors can quite comfortably sit in those asset classes and still earn some decent returns whilst they wait for things to play out.

Paul O’Connor:

Yeah, we've certainly seen, I guess, from the Netwealth platform perspective, the changing allocation of money and such a significant increase of money moving back into cash and true cash type of investments. Because I guess if you're getting paid zero, it worked, it pushed people up the risk spectrum, so to speak. But with that normalisation of interest rates and the return that is available, it does make sense now to, I guess, normalise the defensive portion of your portfolio. China has abandoned its COVID zero policy and is now in the process of reopening its economy. So what are the implications for Australia and the global economy? And I guess thinking ahead, it's probably got to be quite a positive for the Australian economy.

Aaditya Thakur:

Yeah, I think overall in balance, it's positive for the global economy and for the Australian economy at a kind of simple level, it just provides an additional source of demand that otherwise would be lower if China were to have retained their zero COVID policy. For Australia specifically, there should be some positives, both on the inflation front, because with China reopening it should mean an earlier and a more permanent easing of supply chain disruptions. And so that should lead to that disinflation pulse in terms of goods, all the goods that we import from China. So that disinflation pulse from the goods sector should help the inflation pulse in Australia moderate, and that will provide some relief to the RBA and potentially help them to pause their hiking cycle later this year.

And on the demand side, it should also see the return of tourism, potentially students as well from the region, will be a positive in terms of demand and also in terms of adding to our labour supply. So at a time when household consumption is due to start to slow, this additional source of demand from tourism and even from the migration flows, that's also an additional source of demand, so that should kind of help buffer the economy and provide for a smoother path for demand as it slows. So I think overall it should be a positive both on the growth and inflation front for Australia.

Paul O’Connor:

Yes. Well, I mean, I'm just, from a simplistic viewpoint, thinking that if our biggest trading partner can double its GDP growth over the next 12 months, i.e. get back to a 6% plus, that's got to be a very strong positive for our commodities, effectively in the hard commodities. What are the implications of a real return from cash rates and do you think we're going to see this in 2023? And i.e. for the listener, we're talking about where the return from cash is greater than inflation, so you're getting a positive real return?

Aaditya Thakur:

Yeah, I kind of touched on this briefly before. I think you're right, with cash rates getting close to three and a half to 4%, that's what we're kind of expecting and inflation to start moderating towards 4%. The real return on cash is going to be close to zero, if not kind of small positive. And that's going to be the highest real return on cash that we've seen in quite some time, in many years. So again, that comes back to this idea of making that hurdle rate, making the opportunity cost for investors to move out of cash and into other more risky forms of investment, it's making that hurdle rate much higher. When there's increased uncertainty on the growth outlook, investors are now being paid almost a positive real return to stay in cash. And that's part of what central banks are trying to engineer.

They're trying to reduce risk taking, they're trying to slow down economies and they want to slow down spending. They want to see savings increase, spending decrease, and help to cool economies down. So this is all part of what they're trying to achieve. And from an investor's perspective, I think it just means that they've got to be much more discerning about going out the spectrum, much more discerning about liquidity risk and these higher rates of real return in cash and defensive asset classes like fixed income, means that the cost of sitting in those asset classes is pretty low. The cost of waiting and seeing how things play out and whether recession risks do indeed rise, the cost of waiting and sitting in those asset classes is very low. So I think that will be prudent to do that.

And should recession risks do rise, if they are to rise, if credit spreads were to widen to reflect higher recession risks, if equities were to fall to reflect higher recession risks, then at that point it would make sense to redeploy the valuation argument, might be more favourable to then redeploy out of cash and defensive asset classes into those riskier asset classes. But we think that that valuation argument isn't there, and until then, investors should kind of stay a bit defensive.

Paul O’Connor:

So with a genuine yield on offer for high quality fixed interest securities, what does this mean for investors when constructing their portfolios? And I guess to a degree, I'm thinking about the strong rise in private credit and money flowing into private credit in recent years. Should people be rebalancing and perhaps taking a little bit of credit risk off the table and even considering going long bonds, which we haven't seen as a core part of portfolios for many years now?

Aaditya Thakur:

Yeah, I think certainly reducing a little bit of exposure to asset classes that have a high correlation to growth sensitive asset classes like equities, so whether that's equities or high yield or the riskier components of credit, I think that certainly makes sense. Investors can now construct portfolios that yield somewhere between four to 6% by not really taking that much risk. By being in those kind of defensive asset classes like fixed income, like high quality spread product, high quality investment grade credit, you can construct those kind of portfolios with attractive yields, with relatively low risk compared to what you needed to do and what risk you needed to take to generate those kind of yields in the years prior to COVID. So I think with those kind of yields on offer at a much reduced level of risk, I think that makes sense, given the prospect for recession risks to start to rise later this year. That's certainly how we're thinking about overall asset allocation for our multi-asset portfolios.

Paul O’Connor:

So perhaps to finish the podcast and possibly the most difficult question here, Aaditya, with the talk of recession, and we've been talking about the possibility of that this year, and you mentioned that certain asset classes are still trading without potentially taking into account that risk of recession. Is the central bank put option dead or will there be a return to accommodating monetary policy, including quantitative easing? And I guess we're asking is it now in the mindset of the investor that, oh, well the recession won't be too deep, central banks will just reengage QE again and flood liquidity into the markets and equities will rise again to extraordinary multiples, property will keep rising. And I guess it's a very theoretical question there, but I would be interested in your thoughts.

Aaditya Thakur:

Yeah, I think I wouldn't say that the central bank put is dead. I think I would say that the strike for the put is just a lot further away today. And kind of what I mean by that is clearly given inflation has really been driving markets over the last 12 months, the outright levels of inflation are just too high. And central banks are not going to be willing to ease aggressively until they see a lot of success on the inflation side of their mandate, they need to see inflation come down a fair bit and they need to see the trend in underlying inflation come down. So they'll be watching three, six month moving averages in those inflation measures, looking for those kind of trend measures to start coming closer towards their target levels before they start even considering potentially easing monetary policy. So I think there's some distance there between now and central bank's easing monetary policy, but I wouldn't say that it's dead.

Things can change very quickly, we think that the next 12 months, the focus will shift a little bit away from just being about inflation, to becoming more about growth and inflation. And then in 12 months time, you could quite easily envisage that if recessions do eventuate, we might be talking about, or central banks might be thinking about how do we ensure against not returning to an era of very low cash rates? They're going to be careful not to drive economies too much into recession, to end up in the state that we were at prior to COVID. And that's something that we could be easily talking about or thinking about in 12 months time. Things can certainly change very quickly. So I would just say that the central bank put isn't dead, I'd just describe it as being dormant for now.

Paul O’Connor:

Aaditya, thank you very much for joining us this morning on the Netwealth Portfolio Construction Podcast Series. It's been really interesting, I guess, getting your insights into the outlook for inflation. And I guess the positives coming out of it that we do all are starting to think that if there's a recession, it won't be too deep, that we do think inflation is moderating. I guess what I believe is the normalisation of defensive assets in portfolios, that we're now getting a return on cash, there's now fairly attractive returns on bonds and so I guess the more traditional fixed interest securities. So we certainly do appreciate your time and thank you again for joining us on the podcast.

Aaditya Thakur:

Thanks very much, Paul. Thanks for having me.

Paul O’Connor:

To the listener, thank you for joining us again for the podcast today. I hope you found the discussion as enjoyable as I did. And I'll look forward to joining you on the next instalment of the Netwealth Portfolio Construction Podcast Series.

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